The paradox of Gold glittered this week and made me a bit wiser. Apple launched what it called a ‘uniquely luxurious’ Gold Edition Watch priced at $17,000 and allured its customers to the sheen of the yellow metal. Also this week Gold prices witnessed its worst losing streak in more than 40 years with nine consecutive trading sessions of losses. I have been following and learning about Gold Market for about a year and want to share some of my learnings.
This quote from Warren Buffet caught my attention about a year ago –
“If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the “cigar butt” approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.”
The challenge was to find such companies and knowing what publicly available information / data-metric can help me identify such investment opportunities. There are three aspects to this investment strategy – Price, Value and Going Concern i.e. identify companies that have ‘Value’ higher than the listed ‘Price’ and also making sure they will profitably continue in business for a foreseeable future.
I looked at companies that have positive Gross Margins, positive Operating Margins, positive Net Profit, Price to Book Value ratio of less than 1, health of Balance Sheet to realize assets etc. To my surprise I saw a lot of Gold Mining Companies that met these conditions. Many companies were listed for a price less than half of their book value. i.e. hypothetically if the companies were to go into bankruptcy, each share will get more money than what it is bought for. I shortlisted couple of companies and made a small investment. I kept track of these investments on a weekly basis and after couple of months, noted that there was very little change in the price of the stock. In fact I had lost about 5% of my investment value.
To make sure I did not make a stupid decision, I looked at the fundamental aspect of the Gold Industry – Global Demand and Supply. Here are the statistics for 2013 and 2014.
|Demand||4,090 tonnes||3,925 tonnes|
|Supply from Mines||3,050 tonnes||3,115 tonnes|
|Deficit / (Surplus)||1,040 tonnes||810 tonnes|
Having looked at this data I felt good that there is more demand for Gold than what is produced by the Mines and this in the long run should bring the price up. After couple more months, I lost a little more of my investment value. Then I looked at what is driving the demand. Here is what I found out.
Again felt good to note that Jewellery is driving the highest demand for Gold and the size of the demand pie for Jewellery is increasing year over year validating the fact that there is no limit for human greed and public display of wealth. As long as poverty rates are going down and human population is growing up, this demand should continue.
This was the time to practice some patience and wait for Gold price to rise. After couple more months, I again lost a bit more of my investment value (about 12% loss).
Loss and failures are good teachers and I was highly motivated to understand the primary reason for the fall of Gold prices. After some research I learnt that the strength of US Dollar has an inverse relationship to the price of Gold as can be seen from the chart below.
International Gold prices are listed in USD and as USD becomes stronger, local currencies have to pay more to buy Gold. This creates pressures in local markets and that has an adverse impact on the Demand and Supply economics. Also given the US Dollar strength reflects confidence in US Economy, investors prefer to invest in US based stocks and bonds and on top of this when the Federal Reserve increases the interest rates on Government / Treasury Bonds, it also becomes a preferred destination for parking surplus funds. All these more profitable options take away investments from Gold and other non-productive assets. However lower confidence in US Economy and ‘Fear’ about impending financial crisis drive funds out of the Economy into Gold and that drives the prices up.
Wait a second, let us look at the above Gold demand pie again, demand for Gold as an investment option is significantly small compared to the large Jewellery market. Having lived in a culture that heavily consumes Gold, I know demand for Jewellery is more driven by festivals, customs and weddings and less by alternative profitable investment options. Something is wrong in how it is explained. I took a look at a longer term history of Gold price and US Dollar.
Above is the USD vs. Gold from 1970 to 2013. Let us pick 1980, the USD was 85, Gold was at $800. In the early 90s, the USD was again around 85, Gold was $400. While not shown on the chart in 2013, the USD was at 85, Gold was at $1,200. So we have had Gold at $200, $400, $800, and $1,200 while the USD was at 85. The explanation that Gold and US Dollar have inverse relationship does not hold up in the long-term view.
Let us also take a look at the fundamental Demand and Supply dynamics on the price of Gold. Historically the Demand for Gold was always more than the Supply from Mines.
If you take a look at the chart above, you can see that starting 1985 through 2000 demand for Gold peaked but look at the price line, it remained flat. Starting 2005, as the demand for Gold started to fall from the peak levels, the price started to rise. How can we explain this anomaly? The more I started to look to understand the Gold Market, the less it made sense. As you saw, many of the economic rules and principles commonly known were inconsistent with the realities of the Gold Market. I soon realized that I am not alone in not understanding the Gold Market. Look at what these élite people say about Gold Market / Price –
“Nobody really understands Gold prices and I don’t pretend to understand them either,” – Federal Reserve chief Ben Bernanke told the Senate Banking Committee
“I don’t think anybody has a very good model of what makes Gold prices go up or down.” – Janet Yellen at her confirmation hearing and Federal Reserve chief successor
“Value of Gold as a currency is outside of the policies conducted by governments.” – Former Fed “The Maestro” Alan Greenspan
The Market for Gold is not only for Gold. What is actually traded is not Gold but a concept called ‘Paper Gold’ or ‘Derivative Market Gold’. Look at the example below of what is actually traded by this trading house. Real Gold or physical Gold constitutes an insignificant part of the Gold market.
To put the above picture into perspective,
“if Gold trades five days a week, 52 weeks a year, it means that roughly 260,000 tonnes of Gold changes ownership during the course of a year. 260,000 tonnes is almost 8.4 billion ounces of Gold. The total amount of Gold ever mined is only about 137,000 tonnes. All the central banks in the world together own only 31,400 tonnes. The amount of physical Gold that trades every year is, by comparison, a minute 4,500 to 5,000 tonnes, and the annual trade deficit that everyone talks about is an infinitesimal 276 tonnes. The physical Gold market is less than 2% of the size of the derivatives market”
The price of the Gold is not based on the Demand and Supply for real Gold (which is just 2% of the size of the market). Any explanation to rationalize the price of Gold would just be based on some Hindsight Bias and nothing more. Napoleon Hill once said – “More Gold has been mined from the mind of men than the earth itself”. Gold price determination is a game of the mind and not the game of the mines.
All I know is human ‘Greed’ drives the price down; ‘Culture’ keeps the value of Gold intact and ‘Fear’ drive prices up. We as humans beings have the cycles of these emotions / feelings all the time.
Finally Warren Buffet came to my rescue when he said –
“You should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.
Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.
Mr. Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.
But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game.”
As of today my investment in Gold stocks are down 18% and I am waiting for Mr. Market to come to me with a higher price. I guess I’ll keep ignoring him for a long time. Hope the exquisite and ‘uniquely luxurious’ Gold time piece Apple has launched makes you fall in love with Gold, pay a whole lot more than what it is really worth and wonder at the paradox of what you actually paid for.